What Is the Debt Ratio?

The term "debt ratio" refers to a financial ratio that identifies a company’s leverage, or howꦬ much borrowing is used a💯s a source of funding.

The debt ratio is defined as the ratio of 澳洲幸运5官方开奖结果体彩网:total debt to total assets, expressed as a decimal or percentage. It can be inter🍨preted as the proportion of a compan🔯y’s assets that are financed by debt. This is information that's important to sizing up a company's financial health.

A ratio greater than 1 means that a considerable amount of a company's assets is funded by debt. In fact, it indicates that the company has more liabilities than assets.

A high ratio indicates that a company may be at risk of defaulting on its loans if interest rates suddenly rise. A ratio below 1 means that a greater portion of a company's assets is funded by equity.

Debt Ratio Formula and Calculation

As noted above, a company's debt ratio is a measure of the 澳洲幸运5官方开奖结果体彩网:extent of its financial leverage. This ratio varies widely across industries. Capital-intensive businesses, such as utilities and pipelines tend to have much higher debt ratios than other companies in, for instance, the 澳洲幸运5官方开奖结果体彩网:technology sector.

The formula for calculating a company's debt ratio is:

$\begin{aligned} &\text{Debt ratio} = \frac{\text{Total debt}}{\text{Total assets}} \end{aligned}$​Debt ratio=Total assetsTotal debt​​

So if a company has total assets of $100 million and total debt of $30 million, its debt ratio is 0.3 or 30%. Is this company in a better financial situation than one with a debt ratio of 40%? The answer depends on the industry.

A debt ratio of 30% may be too high for an industry with volatile 澳洲幸运5官方开奖结果体彩网:cash flows, in which most businesses take on little debt. A company with a high debt ratio relative to its🧸 peers would probably find it expensive to borrow and could find itself in a cru﷽nch if circumstances change.

Conversely, a debt level of 40% may be easily manageable for a company in a sector such as ut🐻ilities, ꧃where cash flows are stable and higher debt ratios are the norm.

A debt ratio greater than 1.0 (100%) tells you that a company has more debt than assets. A debt ratio of less than 1.0 indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's risk level.

Advantages and Disadvantages of the Debt Ratio

Pros

1. The debt ratio is a simple🍒 ratio that is easy to compute and comprehend.

2. It quickly provides an overview of how much debt a fir🎐m has in comparison to all of its assets—what it owes com🐎pared to what it owns.

3. Because public companies must report these figures as part of their periodic external reporting, the information you need to obtain the debt ra𝕴tio is readily available.

4. The debt ratio aids in determining a company's capacity to service its long-term debt commitments. As discussed earlier, a lower debt ratio signifies that the business is more financially solid and has a lower chance of insolvency due to unpaid debt.

With this information, investors can use historical data to make more informed investment decisions about the company's potential for financial success.

5. Last, businesses in the same industry can be contrasted using their debt ratios. They're a way to determine whether one company's debt levels are higher or lower than those of its competitors.

As is the story with most financial ratios, you can take a company's debt ratio and see how it changes over time, how it compares to competitors', and how it compares to benchmarks.

Cons

1. There are several downsides to the debt ratio as well. It doesn't reveal the type of debt or how much it costs. The terms and interest rates of various debts may differ, which can have a substantial effect on a company's financial stability.

2. In addition, the debt ratio depends on accounting i🐻nformation which may be construed or manipulated by a company for external reports.

3. The debt ratio does not take a company's profitability into account. If its assets provide large earnings, a highly leveraged corporation may have a low debt ratio, making it less hazardous.

Contrarily, if the company's assets yield low returns, a low debt ratio does not automatically translate into 澳洲幸运5官方开奖结果体彩网:profitability.

4. It's great to compare debt ratios across companies; however, capital intensity and debt needs 澳洲幸运5官方开奖结果体彩网:vary widely across sectors. The financial health of 🍃a firm may not be accurately represented by comparing debt ratios across industries.

Bear in miꦅnd that certain industries may necessitate higher debt ratios due to the initial investment needed.

5. Last, the debt ratio is a constant indicator of a company's financial standing at a certain moment in time. Acquisitions, sales, or changes in asset prices are just a few of the variables that might quickly affect the debt ratio.

As a result, conclusions purely based on historical debt ratios that don't take into account future predictions may mislead analysts.

Special Considerations

Some sources consider the debt ratio to be total 澳洲幸运5官方开奖结果体彩网:liabilities divided by total assets. This reflects a certain ambiguity aꦏbout the terms "debt" and "liabilities". (To be clear, liabilities encompass a company's financial obligations and can reflect transactions other tha💝n debt.)

The 澳洲幸运5官方开奖结果体彩网:debt-to-equity ratio, for example, is closely relat⛄ed to and more common than the debt ratio, but it uses total liabi▨lities as the numerator.

Financial data providers calculate it using only 澳洲幸运5官方开奖结果体彩网:long-term and 澳洲幸运5官方开奖结果体彩网:short-term debt (including 澳洲幸运5官方开奖结果体彩网:current portions of long-term debt), excluding liabilities such as 澳洲幸运5官方开奖结果体彩网:accounts payable, 澳洲幸运5官方开奖结果体彩网:negative goodwill, and others.

In the consumer lending and mortgage business, two common debt ratios used to assess a borrower’s ability to repay a loan or mortgage are the gross 澳洲幸运5官方开奖结果体彩网:debt service ratio and the 澳洲幸运5官方开奖结果体彩网:total debt service ratio.

The gross debt service ratio is defined as the ratio of monthly housing costs (including 澳洲幸运5官方开奖结果体彩网:mortgage payments, home insurance, and property costs) to monthly inco🍎me.

The total debt service ratio is the ratio of monthly housing costs plus other debt such as car payments and credit card borrowings to monthly income. Acceptable levels of the total debt service ratio range from the mid-30s to the low-40s in percentage terms.

Debt Ratio vs. Long-Term Debt to Assets Ratio

While the debt ratio (total debt to total assets) includes all debts, the long-term debt to assets ratio only takes into account long-term debts.

The debt ratio takes into account both long-term debts, such as mortgages and securities, and current or short-term debts such as rent, utilities, and loans maturing in less than 12 months.

Both ratios, however, encompass all of a business's assets, including tangible assets such as equipment and inventory, and intangible assets such as copyrights and owned brands.

Because the debt ratio includes more of a company's liabilities, this metric is almost always higher than a company's long-term debt to assets ratio. 

Examples of the Debt Ratio

Let's look at a few examples from different industries to contextualize the debt ratio.

Starbucks

Starbucks (SBUX) listed $1.92 million in short-term and current portion of long-term debt on its balance sheet for the fiscal year ended Oct. 2, 2022, and $13.1 billion in long-term debt. The company's total assets were $28 billion. So 澳洲幸运5官方开奖结果体彩网:Starbuck's debt ratio is $15 billion ÷ $28 billion = 0🥀.5357, or 53.6%.

To assess whether this is high, we should consider the 澳洲幸运5官方开奖结果体彩网:capital expenditures that go into op♉ening a Starbucks, including leasing commercial space, renovating it to fit a certain layout, and purchasing expensive specialty equipment, much of which is used infrequently.

The company must also hire and train employees in an industry with exceptionally high employee turnover, and adhere to food safety regulations for its approximately 18,253 stores.

Perhaps 53.6% isn't that bad when you consider that the industry average was 79% in 2022. The result is that Starbucks had an easy time borrowing money—creditors trusted that it was in a solid financial position and could be expected to pay them back in full❀.

Meta

What about a technology company? For the fiscal year ended Dec. 31, 2022, Meta (META), formerly Facebook, reported:

• Total debt as $26.59 billion
• Total assets as $185.7 billion

Using these figures, Meta's debt ratio can be calculated as $26.59 billion ÷ $185.7 billion = 0.143, or 14.3%. The company borrowed $10.5 billion from the 澳洲幸运5官方开奖结果体彩网:corporate bond market in 2022 for a variety of purposes, including to invest in artificial intelligence (AI).

The Bottom Line

The debt ratio is a metric that measures a company's total debt, as a percentage of its total assets. A high debt ratio indicates that a company is highly leveraged, and may have borrowed more money than it can easily pay back.

Investors and accountants use the debt ratio to assess the risk of a company defaulting on its debts.